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January 2, 2014

Economics of Advertising - Economics for the CEO

Advertising is a pure form of selling cost. This chapter illustrates the general approach of managerial economics to various kinds of marketing or selling outlays.

Nature of Advertising Costs

Advertising costs are designed to increase the demand for the firm's products. Advertising expenditures shift the demand curve to the right of where it would otherwise be.

Selling costs are incurred to the get the business. Production and distribution costs create the product and take it to the market.

Pure selling costs are designed to shift the demand schedule, i.e., to obtain sales that would not otherwise have been obtained at the same price. Selling expenses have no functional relationship to production output. They are a cause of sales or some part of sales. In the short run, sales and hence profit depend on the combinations of price, product improvement or specified functionality and quality, advertising outlay and other selling activities. These four influences are interactive. Advertising can shift the demand curve to the right and also can make demand less elastic.

Promotional Elasticity of Demand

Promotional elasticity of demand measures the responsiveness of sales to changes in the amount of advertising with constant price. Like other elasticity measures, it is the ratio of proportionate chagne in sales to the proportionate change in the advertising that causes the change.

Long-Run Aspect of Advertising

Advertising has long-run impacts apart from shifting the short term demand to the right. It helps a firm to attain strategic advantage in market position and gives it a security that contributes to the long-run profit maximization.

The further discussion in the chapter is focused on three issues.

1. The level of the total advertising expenditure over a period of years.
2. Fluctuations in the annual outlays over the course of a business cycle.
3. Measuring the effects of advertising for planning and control purposes.

1. The Level of Advertising Expenditure

The theory of monopolistic competition provides an opportunity to analyze advertising expenditure and its effect on profit for a monopolist.

Simple theory of behavior of advertising expenditure and its impact: Ad expenditure includes all pure selling costs in the theory. The marginal cost of advertising comes down initially and then it goes up in the short run. A firm can go on advertising till the marginal cost of advertising becomes equal to gross profit (gross profit assumed to be constant).

Methods for determining total advertising budget: While the theoretical rule of marginal cost is equal to gross profit on a unit is rational, firms use more simple thumb rules. They are further discussed in the chapter.

3. Measuring the effects of advertising for planning and control purposes.

One has to measure how much the firm's demand schedule has shifted as a result of a specified amount of advertising outlay. Historical data if available can be studied in two ways. (i) by comparing firms with different advertising outlays and (ii) by comparing a firm's performance over time with different advertising outlays.

While Joel Dean's book authored in 1951 has pointed out that economics of advertising is an important managerial economics issue for top management, it has not provided much content. One has to see the contribution of subsequent authors in this topic to get more useful direction.